Divisional Performance Measurement (ROI and RI).pptx

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1. Divisional p erformance measurement Patrick Robert

2. Introduction In this topic we will consider the situation where an organisation is divisonalised (or decentralised ) and the importance of proper performance measurement in this situation. We will also consider the possible problems that can result from the use of certain standard performance measures . The meaning of divisionalisation Divisionalisation is the situation where managers of business areas are given a degree of autonomy over decision making i.e. they are given the authority to make decision without reference to senior management. In effect they are allowed to run their part of the business almost as though it were their own company. On that ground, it is vital to control their performance, and this is done by establishing in advance a set of measures that will be used to evaluate their performance at (normally) the end of each year. These measures provide a way of determining whether or not they are managing their division well, and also communicate to the managers how they are expected to perform. It is of critical importance that the performance measures are designed well.

3. For example Suppose a manager was simply given one performance measure – to increase profits . This may seem sensible, in that in any normal situation the company will want the division to become more profitable. However, if the manager expects to be rewarded on the basis of how well he achieves the measure , all his actions will be focussed on increasing profit to the exclusion of everything else. This would not however be beneficial to the company if the manager were to achieve it by taking actions that reduced the quality of the output from the division. (In the long-term it may not be beneficial for the manager either, but managers tend to focus more on the short-term achievement of their performance measures .) It is therefore necessary to have a series of performance measures for each division manager. Maybe one measure will relate to profitability , but at the same time have another measure relating to quality . The manager will be assessed on the basis of how well he has achieved all of his measures . We wish the performance measures to be goal congruent , that is to encourage the manager to make decisions that are not only good for him but end up being good for the company as a whole also.

4. Advantages of divisionalisation: Faster decision making More local knowledge More motivation Problems with divisionalisation: How to measure performance of divisions How to ensure goal congruence – what is good for the manager is good for the company .

5. Return on Investment (ROI ) This is a similar measure to ROCE but is used to appraise the investment decisions of an individual department. ROI = (Controllable profit/Capital employed) × 100 Controllable profit is usually taken after depreciation but before tax. Capital employed is total assets less current liabilities or total equity plus long term debt. Use net assets if capital employed is not given in the question. Example 1 Apple plc has divisions throughout the Baltic States. The Pie division is currently making a profit of TZS 82,000,000 p.a. on investment of TZS 500,000,000. Apple has a target return of 15%. The manager of Pie is considering a new investment which will require additional investment of TZS 100,000,000 and will generate additional profit of TZS 17,000,000 p.a . Required Calculate whether or not the new investment is attractive to the company as a whole . Calculate the ROI of the division, with and without the new investment and hence determine whether or not the manager would decide to accept the new investment .

6. Example 2 The circumstances are the same as in example 1, except that this time the manager of the Pie division is considering an investment that has a cost of TZS 100,000,000 and will give additional profit of TZS 16,000,000 p.a. Required Calculate whether or not the new investment is attractive to the company as a whole . Calculate the ROI of the division, with and without the new investment and hence determine whether or not the manager would decide to accept the new investment .

7. Example 3 Nipo Co has two divisions with the following information: Division A Division B TZS TZS Profit 90,000,000 10,000,000 Capital employed 300,000,000 100,000,000 ROI 30 % 10 % Division A has been offered a project costing TZS 100,000,000 and giving annual returns of TZS 20,000,000. Division B has been offered a project costing TZS 100,000,000 and giving annual returns of TZS 12,000,000. The company’s cost of capital is 15%. Divisional performance is judged on ROI and the ROI –related bonus is sufficiently high to influence the managers’ behaviour . Required: What decisions will be made by management if they act in the best interests of their division (and in the best interests of their bonus )? What should managers do if they act in the best interests of the company as a whole ?

8. Evaluation of ROI as a performance measure Advantages It is widely used and accepted since it is line with ROCE which is frequently used to assess overall business performance. As a relative measure it enables comparisons to be made with divisions or companies of different sizes. It can be broken down into secondary ratios for more detailed analysis, i.e. profit margin and asset turnover. Disadvantages It may lead to dysfunctional decision making (Refer Example 2 and 3). ROI increases with the age of the asset if carrying values are used, thus giving managers an incentive to hang on to possibly inefficient, obsolescent machines. It may encourage the manipulation of profit and capital employed figures to improve results, e.g. in order to obtain a bonus payment. Different accounting policies can confuse comparisons (e.g. depreciation policy). In example 2 and 3, the manager is not motivated to make a goal congruent decision. For this reason, a better approach is to assess the managers performance on Residual Income.

9. Residual income ( RI) Instead of using a percentage measure, as with ROI, the Residual Income approach assesses the manager on absolute profit. RI = Controllable profit – Notional interest on capital Controllable profit is calculated in the same way as for ROI. Notional interest on capital = the capital employed in the division multiplied by a notional cost of capital or interest rate. Example 4 Apple plc has divisions throughout the Baltic States. The Pie division is currently making a profit of TZS 82,000,000 p.a. on investment of TZS 500,000,000. Apple has a target return of 15%. The manager of Pie is considering a new investment which will require additional investment of TZS 100,000,000 and will generate additional profit of TZS 17,000,000 p.a. Required Assume the manager is assessed based on RI, determine whether or not the manager would decide to accept the new investment .

10. Example 5 The circumstances are the same as in example 4, except that this time the manager of the Pie division is considering an investment that has a cost of TZS 100,000,000 and will give additional profit of TZS 16,000,000 p.a. Required Assume the manager is assessed based on RI, determine whether or not the manager would decide to accept the new investment . Example 6 An investment centre has net assets of TZS 800,000,000 and made profits before interest of TZS 160,000,000. The notional cost of capital is 12%. This is the company's target return. An opportunity has arisen to invest in a new project costing TZS 100,000,000. The project would have a four-year life, and would make profits of TZS 15,000,000 each year. Required: What would be the ROI with and without the investment? Would the investment centre manager wish to undertake the investment if performance is judged on ROI? What would be the average annual RI with and without the investment ?. Would the investment centre manager wish to undertake the investment if performance is judged on RI?

11. Evaluation of RI as a performance measure Compared to using ROI as a measure of performance, RI has several advantages and disadvantages: Advantages It encourages investment centre managers to make new investments if they add to RI . Making a specific charge for interest helps to make investment centre managers more aware of the cost of the assets under their control. Risk can be incorporated by the choice of interest rate used: different interest rates for the notional cost of capital can be applied to investments with different risk characteristics. Disadvantages It does not facilitate comparisons between divisions since the RI is driven by the size of divisions and of their investments. It is based on accounting measures of profit and capital employed which may be subject to manipulation, e.g. in order to obtain a bonus payment.

12. Comparing divisional performance Divisional performance can be compared in many ways. ROI and RI are common methods but other methods could be used. Variance analysis – is a standard means of monitoring and controlling performance . Care must be taken in identifying the controllability of, and responsibility for, each variance. Ratio analysis – there are several profitability and liquidity measures that can be applied to divisional performance reports. Other management ratios – this could include measures such as sales per employee or square foot as well as industry specific ratios such as transport costs per mile, brewing costs per barrel, overheads per chargeable hour. Other information – such as staff turnover, market share, new customers gained , innovative products or services developed